Alcoa 2003 Annual Report Download - page 63

Cash Flow Hedges
Interest Rates. Alcoa also uses interest rate swaps to establish fixed
interest rates onanticipated borrowings between June 2005 and
June 2006.The anticipatedborrowingshaveahigh probability of
occurrence because the proceeds will be used to fund debt maturities
and anticipated capital expenditures. Alcoa has $1,000 of interest
rate swaps outstanding that will establish fixed interest rates on
anticipated borrowings of $500 of debt through 2016 and $500
of debt through 2036.
Currencies. Alcoa is subject to exposure from fluctuations in
foreign currencies. Foreign currency exchange contracts may be
used from time to time to hedge thevariability in cash flows
from the forecasted payment or receipt of currencies other than
the functional currency. Alcoa’s foreign currency contracts were
principally used to purchase Australian dollars, Brazilian reais,
and Mexican pesos. The U.S. dollarnotionalamountofallforeign
currency contracts was $203 and $798 as of December 31, 2003
and 2002, respectively.
Commodities. Alcoa anticipates the continued requirement to
purchase aluminum and other commodities such as natural gas,
fuel oil, and electricity for its operations. Alcoa enters into futures
contracts to reduce volatility in the price of these commodities.
For these cash flow hedge transactions, the fair values of the
derivatives are recorded on the Consolidated Balance Sheet. The
effective portions of the changes in the fair values of these deriva-
tives are recorded in other comprehensive income and are reclassi-
fied tosales,costofgoodssold,orinterest expense in the period in
which earnings are impacted by the hedged items or in the period
that the transaction no longer qualifies as a cash flow hedge. There
were no transactions that ceased to qualify as a cash flow hedge in
2003. These contracts cover periods commensurate with known or
expected exposures, generally within three years. Assuming market
rates remain constantwiththe rates at December 31, 2003, $33 of
the$66 gainincluded in other comprehensive income is expected to
be recognized in earnings over the next 12 months.
Alcoa is exposed to credit loss in the event of nonperformance by
counterparties on the above instruments, as well as credit or perfor-
mance risk with respect to its hedged customers’ commitments.
Although nonperformance is possible, Alcoa does not anticipate
nonperformance by any of these parties. Contracts are with credit-
worthy counterparties and are further supported by cash, treasury
bills, or irrevocable letters of credit issued by carefully chosen
banks. In addition, various master netting arrangements are in place
with counterparties to facilitate settlement of gains and losses on
these contracts.
For additional information on Alcoa’s hedging and derivatives
activities, see Note A.
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The methods used to estimate the fair values of certain financial
instruments follow.
Cash and Cash Equivalents, Short-Term Investments, and Short-
Te r m D e b t . The carrying amounts approximate fair value because of
the short maturity of the instruments.
Noncurrent Receivables. The fair value of noncurrent receivables is
based on anticipated cash flows which approximates carrying value.
Available-for-Sale Investments. The fair value of investments is
based on readily available market values. Investments inmarketable
equity securities are classified as ‘‘available for sale’’ and are carried
at fair value.
Long-Term Debt. The fairvalueisbasedoninterestratesthatare
currently available to Alcoa for issuance of debt with similar terms
and remaining maturities.
Derivatives. Alcoa uses derivative financial instruments for
purposes other than trading. Detailsofthefairvalue gains (losses)
of the significant instruments follow.
December 31 2003 2002
Aluminum $70 $(14)
Interest rates (74) 80
Foreig n currency (6) 57
Other commodities 73 51
Fair Value Hedges
Aluminum. Customers often require Alcoa to enter into forward-
dated, fixed-price commitments. These commitments expose Alcoa
to the risk of fluctuating aluminum prices between the time the
order is committed and the time that the order is shipped. Alcoa’s
aluminum commodityriskmanagement policy is to manage, through
the use of futures contracts, the aluminum price risk associated
with a portion of its fixed-price firm commitments. These contracts
cover known exposures, generally within three years.
Interest Rates. Alcoa uses interest rate swaps to help maintain
astrategic balance between fixed- and floating-rate debt and to
manage overall financing costs. The company has entered into pay
floating, receive fixed interest rate swaps to effectively convert the
interest rate from fixed to floating on $4,150 ofdebt,through 2013.
For additional information on interest rate swaps and their effect
on debt and interest expense, see Note K.
Currencies. Aluminio uses cross-currency interest rate swaps that
effectively convert its U.S. dollar denominated debt into Brazilian
reais debtatlocalinterest rates.
Hedges of theseexisting assets, liabilities, and firm commitments
qualify as ‘‘fair value’’ hedges. As a result, the fair values of deriva-
tives and changes in the fair values of the underlying hedged items
are reported in the Consolidated Balance Sheet. Changes in the fair
values of these derivatives and underlying hedged items generally
offset and are recorded each period in sales, cost of goods sold,
interest expense, or other income, consistent with the underlying
hedged item. There were no transactionsthatceasedtoqualify
asafairvaluehedge in 2003.